Desperate times call for desperate measures. This adage would be apt for Lakshmi Niwas Mittal, who lords over the biggest steel empire in the world but is currently stuck on a hot tin roof. ArcelorMittal, a company that produced 98 million tonne of steel last year, compared with the world’s second-largest producer Nippon Steel, which produced only 49 million tonne, is grappling with a downturn in the steel industry. This situation is a result of the Chinese steel industry dumping its output across global markets, rendering just about every steel-maker across countries uncompetitive. Last year, China exported a record 93 million metric tonne (MT)of steel and in the first six months of 2015, China’s steel exports increased 27%, creating a glut in international markets that is, in turn, pulling down steel prices.
The desperation is such that Mittal is urging South Africa’s president Jacob Zuma to impose a 10% import duty on Chinese steel in return for Africa’s largest steel-maker, ArcelorMittal South Africa will offer shares to black empowerment partners. With $2.8 billion in cash, $6 billion in credit lines and over $4 billion in cash flows from operations, ArcelorMittal appears to be in a better place to weather the downturn. Other steel-makers across the world might not be as lucky. US Steel Co, the largest metal producer in the US, is predicting doomsday. US Steel CEO Mario Longhi was quoted in an interview saying, “If the US doesn’t raise tariffs on Chinese steel imports, it could put at risk the existence of this industry.”
Back home, Cyrus Mistry is facing his biggest challenge since taking over the mantle of India’s biggest conglomerate. Tata Steel continues to report losses even after spending £6.2 billion on acquiring Corus and investing a further £1.2 billion on restructuring. As of March-end, Tata Steel’s consolidated net debt was ₹69,000 crore. Though the company has no cash flow issues and can service its debt, its ability to hold on for long with falling prices and surging imports looks difficult.
Mistry, in the steel-maker’s latest annual report, has stated that the company may be forced to further reduce assets in its Europe business. Tata Steel Europe has already put its long products business on the block.
According to brokerage Credit Suisse, the domestic steel industry has $50 billion debt, 10X of what steelmakers earned in the last financial year before interest, taxes, depreciation and amortisation. Against such a backdrop, union steel and mines minister Narendra Singh Tomar’s sense of pride while recently announcing that India has overtaken the US to become the world’s third-largest steel producer seems ironical.
To understand the context of Indian steelmakers’ trouble, it is critical to understand the origin of the problem.
The pain point
China, which produces as much crude steel a year as rest of the world put together, is increasingly becoming a threat for the world steel industry. Because of its slowing economy and domestic demand, large capacities now being diverted to exports have hit the global steel prices. China’s steel demand, which grew at around 10% between 2008 and 2013, fell to around 2% in 2014 and continues to taper in the current year as well.
As China — which accounts for 70% of the region’s steel demand — experiences weakening trends in real estate, infrastructure and manufacturing, ratings agency Moody’s Investor Services expects steel demand to dwindle further even as production continues, pressuring steelmakers. Overseas sales from China rose to 52.4 million MT in the first half, equivalent to Japan’s entire crude steel production of 52.6 million tonne during the same period. Making this observation, Credit Suisse analyst Shinya Yamada, in a July 27 report, mentions: “Considering that Japan’s crude steel output is second only to China’s, it implies that Chinese exports have risen to extraordinary levels.” Making matters worse, the China Iron and Steel Association expects domestic steel demand to fall 6% year-on-year in 2015 but production to fall only about 1% over this period.
This compounds the problems in an already dwindling world steel industry, as major countries such as Europe, the US and Japan had been facing slow demand. Between January and May this year, the world steel production declined by 1.2%, followed by a 0.5% decline in Chinese production. No wonder then the steel prices today are below the levels of what we saw post the 2008 world economic crisis. If experts are to be believed, the recovery is going to be far and slow. “During the 2008 crisis, there was a V-shaped recovery in steel demand and prices as a result of Chinese demand. Today, it’s the reverse,” points out Ajay Srinivasan, director, Crisil Research.
Seshagiri Rao, joint managing director, JSW Steel, says, “Many Chinese mills are supplying steel below their cost of production, which is putting a lot of pressure on global steel prices.”
Countries such as India, after a long time, turned into a net importer of steel. India, which consumed close to 20 million tonne of steel during the first quarter of the fiscal 2016, saw imports surging by 53% to 2.45 million tonne. This obviously set alarm bells ringing among local producers, who are clamouring for increased import duty to protect the domestic industry. In June, the government raised the import duty on long products, which are usually used in the construction and real estate sector, from 5% to 7.5%.
Similarly, the duty on flat products, which find application in automobiles and the white goods industry, were revised from 7.5% to 10%. But that hardly made a difference. “Increase in import duty had no impact. Post the additional duty of 2.5%, China has reduced steel prices by 5%,” laments Jayant Acharya, director commercial and marketing, JSW Steel. Total flat steel imports in FY15 increased 41% to 4.5 million tonne and in the first quarter of the current financial year,they are already up 57% to 1.55 million tonne.
Leverage pangs
According to research done by Outlook Business, 12 listed steel companies are sitting on a cumulative debt of ₹20,3694 crore on a net worth of ₹76,883 crore, which effectively means a debt to equity of 2.65X. If the top two steelmakers Tata Steel and JSW Steel are excluded from the list, the remaining mid-size companies are making a quarterly loss of about ₹1,200 crore. If they continue to post losses at the same pace, they will completely wipe out their net worth sooner rather than later, which effectively means that there will be nothing left for the shareholders. To put this in perspective, Jindal Stainless has seen its net worth eroding from close to ₹2,200 crore in FY11 to about ₹54 crore today because of losses.
Today, at its current market price, the equity value of the company comes to a mere ₹892 crore. Now compare this with the lenders’ exposure of over ₹12,000 crore — in a manner of speaking, the company is practically owned by its lenders a la Kingfisher. If the company’s current quarterly losses continue (₹17 crore loss in the March 2015 quarter), within another three more quarters, its entire net worth will be wiped out. Jindal Stainless is not alone, companies such as Monnet Steel, Visa Steel, Jai Balaji and Godawari Power and Electrosteel run similar risks. Even the ArcelorMittal-owned Uttam Galva Steel is facing tough times with a debt- equity ratio of over 3X.
Falling prices have not only put the pressure on larger integrated players, but also on midsize and marginal players. In the March quarter, most marginal and small players reported huge losses. This despite a correction in the raw material prices. Since January this year, the iron ore prices have dropped close to 30% from $71 per tonne to $50 a tonne currently. Similarly, coking coal prices have fallen by 18% from $110 to currently at $90 a tonne currently. For every tonne of steel made, about 1.6 tonne of iron ore and about 0.8 tonne of coking coal is required.
Taking that benchmark into consideration, in January this year, for making 1 tonne of steel, the raw material would have cost around ₹12,400, or $200, per tonne, which has come down by almost 27% to ₹9,000 or $146 a tonne. This certainly has given some elbowroom to the manufacturers but the extent of the fall in steel prices has been sharper. Since January this year, the landed cost of steel has fallen from close to ₹33,000 a tonne to ₹23000 a tonne currently or about a 30% correction.
Dinesh Gandhi, director, Godawari Power, says: “Raw material prices have fallen but they have not fallen, but enough to compensate the correction in the steel prices, which is why you would notice that margins are coming down. At today’s price, the domestic steel industry is not at all competitive, as there will be companies that are not even able to cover their costs, particularly the non- integrated players.”
Among other names are non-integrated players such as Electrosteel Steels, OCL Iron and Steel, Surana Industries, Adhunik Metaliks and Visa Steel, which have all reported negative operating margins in the March quarter, indicating that at the current prices, many of them are actually not profitable.
Since March 2015, imported steel prices have fallen from ₹27,000 a tonne to ₹23,000 a tonne, or about 15%. During this period, prices of iron ore and coking coal have corrected to 6% and 18%, respectively. This means that the companies will be sitting on high-cost inventories of both raw material and finished goods, which will negatively impact the profitability in the coming months. Beyond operational issues, analysts also believe that companies are facing huge liquidity problems, which might further lead to pressure on profitability or impact their business.
What is worse for Monnet and a few other companies such as Electrosteel, Usha Martin and Prakash Industries, the problems are far more complex as their coking coal captive mines were cancelled by a recent high court order. On top of that, the HC directive had slapped an additional levy of ₹295 per tonne. The situation was so grim that not only did they have to buy coal at higher prices from the market, but also had to bear this additional levy. The case in point is Usha Martin, whose two coal mines the Kathautia coal block, which was in operation since 2010, and Lohari Coal block (non-operational) were de-allocated. As a result, the company had incurred ₹84 crore in levies in FY15 and had write downs of ₹16 crore on assets and investments made in de-allocated coal blocks.
“Small and marginal players are hit on three counts — competition, cost and price. Unlike larger players, their operating costs, both fixed and variable, are quite high. Though raw material prices have corrected, they are still relatively high,” explains Srinivasan.
Chandrahas Chaudhary, India country head, JC Resources, a South Korea-based raw material supplier, believes that the crisis is bigger than the one that was seen in 2008. “Many smaller players are on the verge of going out of business. Companies have no choice but to either default or delay payment to suppliers because their priority is to pay interest to the bank first.” As a result, the payment terms are getting tighter.
Unlike in the past, when clients were giving credit, today, the trade is taking place in advance. Concurring with this observation is Goutam Chakraborty, analyst at Emkay Global Financial. “Our channel check suggests that today, the suppliers of raw material are not supplying without advance payment, while on the other hand, these steel companies are squeezed by their exposure to infrastructure, real estate and other stressed sectors, where payments are not coming promptly.”
Tipping point
The problem of leverage is snowballing. India is on course to add almost 7 million tonne of new steel capacity in the current financial year. In other words, these new units can’t make enough money to service the debt. Neelkanth Mishra, chief India strategist at Credit Suisse, writes that even last year, when some interest costs on capacities under construction were not included, the average interest cost per tonne of production was nearly $50. “This year, it should be higher, as those capacities get commissioned, and operating profits should be lower — the industry, as a whole, may not be able to pay interest on its debt.” Mishra points out that some companies have interest costs upwards of $250 per tonne and it would be very difficult for them to become viable.
Agrees Srinivasan of Crisil adding. “Domestic prices are quoting at a premium of ₹1,500-2,000 a tonne over imported steel. More than that, even if we believe that the prices will not fall from here on, the damage is already done. India steel mills’ average realisations were in the region of about $450 per tonne in 2014; today most of them are selling below $330 a tonne.”
What goes up...
Steel prices in China have hit a 12-year low thanks to excess capacity
Putting the company’s over ₹100 crore loss in Q1 FY16 in perspective, Seshagiri says, “Had we not incurred an inventory loss, our Ebitda margins would have been better by 250 basis points. If the prices do not fall further, the problem of inventory losses will not be there in the coming quarter. However, if raw material prices fall, there would be more inventory losses.”
It is quite obvious that with falling profitability and lower volumes, the companies’ interest coverage is falling. The top 15 companies are sitting on a gross debt of over ₹1 lakh crore, with their debt to equity at an alarming stage and many of them not generating enough profits to cover up the interest cost. Importantly, 60% of this debt is accounted for three companies namely Bhushan Steel, Jindal Stainless and Monnet Ispat, which are currently operating at a loss because of interest cost. The largest one is Bhushan Steel, which has seen 85% erosion in its market capitalisation.
The company is in severe distress as a result of adverse industry scenario. Because of the soft demand in user industries such as auto and white goods, its volumes fell from 2.3 million tonne in FY13 to about 1.9 million tonne in FY15. This happened at a time when it commissioned 2.5 million tonne new capacities, taking its utilisations to below 40%. As a result of this, the company is not able to service the interest cost incurred on borrowed funds for the existing and new manufacturing facilities. In the March quarter, it made profit before interest of about ₹434 crore, which was not enough to cover the interest cost of ₹796 crore for that quarter, thus resulting in a loss of ₹361 crore.
Companies such as Monnet Ispat are making losses even at an operating level. In FY15, its steel business, on a turnover of ₹3,100 crore, reported ₹554 crore loss at the Ebita level. Because of the debt, part of which is due to its diversification in the power sector, the company is already in a severe financial crunch. It recently defaulted on the payment of the second installment on account of additional levy of ₹295 per tonne, adding up to the ₹20 crore it was supposed to pay for the cancelled coal blocks by the Supreme Court earlier.
“Help won’t come easy for the sector and for a good enough reason,” points out Mishra who writes that the outstanding debt is nearly four times the total market capitalisation of the sector, ruling out equity issuance as a solution. “Worse, the economic value of these plants is now much below the cost of building them, even if those costs were not padded up.”
The results of leading banks for Q1FY16 of the current fiscal are already showing signs of stress, with higher provisioning for steel exposure dragging down profitability. Analysts feel that the government is in no position to give state-run banks the $15 billion in fresh capital that they need against the budgetary allocation of $1.25 billion, given its own limited fiscal leeway.
Most companies are now either restructuring debt, capitalising interest costs or looking to sell assets. Monnet is in the news for selling its power assets to JSW Energy, Jindal Stainless is demerging its businesses so that it can lower its debt in the parent company and there is a buzz that Tata Steel is making a bid for Electrosteel Steel, which has its operation in Jamshedpur.
The Street seems to have already given up on the sector, with steel stocks losing close to 30% of their market capitalisation on average, coming on the back of an average 43% fall in CY14. Importantly, marginal players having higher financial leverage have suffered the most. For instance, companies such as Monnet Ispat, Godawari Power, Uttam Galva have lost close to 50% of their market cap since the year began. What’s worse: the pain has just begun.
